Is this Bond Safe?

In a long interview found at WSJ.com, Jim Rogers expressed his opinion, which I share, that the U.S. government debt is out of control. At some point soon, most likely within the next five years, there will be a crisis involving a collapse of the USD and a spike in inflation that hopefully will cause the U.S. government to deal with the problem. It will take a crisis before the government and the American citizens finally come to grips with their debt addictions. I disagree with most of his other views expressed in the interview.  Rogers has a 19th century view of the government's role in the economy. He would have allowed the U.S. to sink into another Great Depression in 2008 and would oppose virtually any financial regulations.  In another interview, Rogers said that he was short stocks and long commodities and currencies.  CNBC.com

The Labor Department reported that initial unemployment claims rose again, increasing to 427,000 when the consensus expectation was a decline to 422,000. ETA Press Release: Unemployment Insurance Weekly Claims Report  The claims number continues to confirm an overall weak jobs market.  The market started to weaken several weeks ago when the claims number started to move back up.

The decline in U.S. home values is now estimated to be greater than the percentage decrease during the Great Depression. SmartMoney.com

1. Is this Bond Safe?: I am always willing to respond to readers questions or comments. I may not have an answer but will instead provide a framework for the reader to analyze the problem. Each investor has to make their own informed decisions. 

One frequent question involves whether a particular bond is "safe". I understand why the question is being asked, a reader may want reassurance that the company will make timely interest payments and will survive to pay off the principal amount at maturity. I believe that is just the wrong question to ask.  And, it can not be answered with  certainty anyway.  

The first inquiry has to be an identification of the risks.  For bonds, there are two critical risks, broadly described as credit risk and interest rate risk.

Many of the junk bonds that I own have significant credit risks, but the interest rate risks are less important due to their short maturities.

A person's situational risk, a risk unique to the individual, may enhance the risk of owning a bond. If the investor has to sell a bond before maturity due to a need for the cash, then both the interest rate and credit risk of owning that bond is enhanced for that particular individual. The bond may be falling in value due to some credit event, market dynamics (supply/demand), or a rise in rates at the time of the sale, whereas those factors might not ultimately impact the timely payment of interest and the payment of par value at maturity.

Situational risks become more problematic for those individuals for longer duration bonds.  An investor may be able to hold bonds maturing before 2020, but can not wait for a bond to mature in 2032.

Situational risks can take many forms. An investor might need the funds in retirement to meet living expenses, or to pay college tuition or medical bills, or to fund a divorce settlement.  

Another situational risk, frequently ignored, is the need for income to meet living expenses. An investor could put all of their funds into 3 month Treasury bills, and receive virtually nothing for their money.  Or, the investor could buy investment grade bonds and receive maybe 2% or 3% by going out five to ten years, or longer. If that income stream is insufficient, then their is obviously a situational risk following that approach. Depending on the investor's circumstances, a too conservative approach may actually entail the most risks. 

So, a proper assessment of the investor's situational risk has to be made, and I can only make that judgment for myself and my family members. I personally have no situational risk. Most likely, I will never need the funds in my retirement accounts and will end up at my death with a Roth IRA untouched during my lifetime. 

An analysis of credit risk needs to be done independently of credit ratings. This requires the investor to exercise their own judgment after performing their own time consuming and laborious research. The credit ratings can be one factor in that analysis, but it would be foolish to place reliance on the rating agencies exclusively, given their track record over the years, most recently the assignment of AAA ratings to toxic mortgage pools. The only way to perform this analysis is to keep track of the firm's earnings on a quarterly basis and to review any important news development. For those who do not want to do the work, then a bond fund is probably a better answer. I would prefer now bond funds with term dates. 

The market may also give a signal about credit problems when the price of the bond is out of line with its credit rating. I would certainly pay attention to that kind of signal, recognizing that institutional bond investors have a lot of good people working for them capable of digging deeper than any individual investor, no matter how sophisticated.  

And there are some general points that need to be kept in the forefront. Junk bonds will perform much worse than investment grade bonds in an economic downturn. But, when it becomes clear that the economy will improve, and the prices have been smashed, the rally off the low can be extremely robust.  The potential for a downturn in the economy now makes junk bonds more dicey than they have been since March 2009, and the spreads to investment grade bonds make many of them unattractive given their enhanced credit risk.  Some junk bonds are way over priced now in my opinion given their risk profile and their current yields.   

The question to ask is not whether the bond is safe. Instead, given your unique situational risks, and tolerance for volatile price movements, what is the overall balance of risks and rewards at a particular moment in time. That balance may change next month or next year, or sometimes the next day.   

What can be said with any degree of certainty about interest rate risk?  I would just say that a longer duration has more risk, and a higher quality bond may go down in price more when a rise in rates is caused by a robust economic recovery.  In that later scenario, a junk bond may even go up in value, due to the improved credit profile and potential upgrades in the debt ratings, while a U.S. treasury security with a similar maturity would fall in price and rise in yield. Obviously, a long bond maturing in 2032 is going to have a lot more interest rate risk than a bond from the same issuer maturing in 2015, with the same credit profile. I can say with a high level of confidence that the 2032 bond will have many occasions in the future where its value will be adversely impacted by a rise in rates.  Maybe that will not occur this week or this month, but it will happen.  

I do not need to be told that bad things will happen if I hold onto my long bonds too long. Over a long period of time, a lot of bad things can happen, many of which can not be anticipated no matter how many MIT pets are employed to protect you from risks.

Even if an investor can hold the bond until 2032 or 2035, there is the risk of lost opportunity. While my funds are tied up in that long bond yielding 7%, I could have used those funds to buy the same bond with a 10% yield. 

Part of the junk bond strategy is based on an expectation that rates will rise in the coming years.  Hopefully, I will avoid losing money on the bonds on a net basis, while receiving an average coupon about 4% to 5% higher than lower tier investment grade bonds with similar maturities.  Given the short average duration of the junk bond portfolio, I hope to roll over the proceeds from maturing issues into investment grade bonds at much higher rates than prevailing now.  So my Junk Bond Ladder Strategy is a transition strategy, not a long term strategy by any means.  The OG is uncomfortable holding most of those bonds.  But Uncle Ben has forced the OG to take risks which he would prefer to avoid given the relentless Fed Jihad against savers and responsible Americans. 

This discussion does not cover all of the variations and factors that need to be addressed.  For example, what do I do with a long term bond now, where I have a large capital gain, but I really have no reinvestment opportunity to replace the income with a similar risk investment?  An example is this small position in the TP JWF, where I have already booked a profit and still own 50 shares. This TP from Wells Fargo is trading near its $25 par value. The coupon is 5.625% and the junior bond matures in 2034: 

JWF Wells Fargo TP Unrealized LT Gain Average Cost $9.55

If this bond was in an IRA, I would just sell it. I would pare the position if I owned 100 shares or more. If I believed that Wells Fargo would not redeem this TP prior to its 2034 maturity, I would sell it now in a taxable account to book the long term capital gain, pay the 15% long term capital gains tax and just forget about it.  What is this TP going to sell for when interest rates rise to normal levels?  This one is a week to week call.

Wells Fargo has already started to redeem some of its TPs (Form 8-K), since their use as TIER 1 capital will have to be phased out for WF. I recently lost KTV to such a redemption. Item # 5 KTV REDEMPTION There is no guarantee that Wells will redeem this TP. If someone agreed to loan me money for 23 years at 5.65%, and my only obligation was to make tax deductible interest payments on a quarterly basis, that lender would not be paid back a day early, unless the lender would allow me to borrow the same amount of money at a lower rate. The beauty of the TP for the bank is that the interest payments are deductible, but the TP was counted as part of their TIER 1 equity. What can you say?  Why would anyone allow a bond to be treated as equity capital!   

Another type of issue is what to do with 100 shares of PFK, a senior bond from Prudential that matures in April 2018 at its $25 par value and is currently selling at over $27. I am not concerned about the interest rate or credit risk.  In addition to the relatively short maturity, which reduces interest rate risk, this bond is a CPI floater. So if inflation increases, so does my monthly interest payment. But, I still have a problem:

100 Shares Taxable Account Average cost per share $18.55- Unrealized Long Term Capital Gain Taxable Now at 15%

  

If I hold this bond to maturity, I will lose over $200 of my long term capital gain and I may have to pay a higher tax on the gain.   For the shares in the retirement account,  I have decided to just hold the bond to maturity and collect the monthly interest payments, foregoing the additional profit which I could realize by selling the shares now. The problem in the taxable account is more complex. 

Another issue is the difficulty that individual investor will have trading bonds in the bond market.  From the summer of 2008 until late last year, I focused on purchasing exchange trade bonds. The rules for trades on the stock exchange are far more fair to an individual wishing to place small trades than the normally unfriendly bond market. 

I will just highlight one example tomorrow involving my one Macy's 2030 bond which I do not want to sell now, unless of course I could actually receive the "third party" price of around 120. I will use an attempt to sell it to highlight one of the many problems faced by small investors. Many investors are not allowed by their brokerage firms to even buy junk bonds online. While Vanguard permits it, the commission is outrageous at $50 and I can not sell what I buy online.  Fidelity is by far the best of the six or so brokerage firms that I user for those trades in junk bonds in the bond market, but I am going to criticize some of their practices tomorrow. 

It is more than the spread between bid/ask prices or the availability of bonds in small lots (less than 5) or the ability to sell in small lots, both of which are usually extremely difficult problems to navigate for the small investor navigating the bond market. If I was willing to trade five or ten bonds at a time, it would be easier. But I am buying junk bonds in the bond market and I am not about to risk several thousand on a particular bond, preferring to disperse my risk in small lots among a number of issuers.  

 For an exchange trade bond at several of my brokerage firms, I can place an AON limit order for 100 shares. Or, I could place a limit order at the ask price for an odd lot, and have the order accepted and filled promptly.  The bond market is far from a friendly place for a small investor and is in need of regulation by the SEC on several critical matters.  The liquidity risk is substantial for a small investor buying in the bond market, compared to buying exchange traded bonds in the stock market.  Some exchange traded bonds, particularly those that trade in the Grey Market, also have liquidity risks.  I would not want to have to sell SSRAP in a hurry or after an adverse credit event at Sears. 

No trades were made yesterday. I found the rally to be unconvincing. And the rally started to fade toward the close. The ^VIX fell 5.85% to close at 17.69. As long time readers are aware, I have models that require me to do something even if I do not want to do it. "LBs stinking rules", RB added.   One of them, the Vix Asset Allocation Model, may soon force me to add to my stock position. ^VIX Historical Prices  The VIX has been moving continuously below 20 since March 22, 2011.  The OG is hoping for a significant pop over 20 before June 22nd.  Maybe LB will allow a violation of its trading rules, the OG was heard to say late in the day. already starting to tremble at the thought of buying more stocks.  "How can there be a lasting recovery when home prices continue to decline", the OG asked the LB who just ignored the Old Goat's question, while pondering the million or so variables and alternate scenarios, and working on a modification to Rule # 1,432,425,453,853 (A)(1)(b)(iii) of its trading rules.   LB's final remark was to suggest that the OG undergo further rehabilitation at the Old Folks home before being allowed to make suggestions to LB, possibly a few more weeks of being submersed head first in a vat of phosphatidylserine will improve the OG's ability to engage in intelligent conversation with the LB.